Banking on greater capital

The Labor Department reported last week that the U.S. economy added fewer jobs than expected in December. The disappointing figure suggests that the recovery remains fragile. Indeed, an hour after the announcement, Federal Reserve Chairman Ben Bernanke told the Senate Budget Committee that job creation will very likely take four to five years to normalize.

One big lesson of the economic crisis is that financial institutions must be better capitalized. Banks use capital as the buffer to absorb losses without threatening their viability or, more important, the broader financial system. Higher levels of capital, and higher-quality capital, can strengthen the global banking system — making it more stable and resilient in the face of economic shocks.

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But more capital alone cannot ensure financial stability. Indeed, higher levels of capital imply lower levels of lending and credit availability. Care must be taken to ensure that requirements of greater levels of higher-quality capital do not impair the still-fragile economic recovery.

Members of the G-20 have been actively addressing bank capital requirements through the Basel Committee on Banking Supervision, which develops best-practice global capital standards. The committee has announced a substantial strengthening of existing capital requirements. For the first time, it has mandated global leverage and liquidity requirements, as part of a new international regime — labeled Basel III.

These new rules deliver on the core of the G-20’s global financial reform agenda and are a strong response to the lessons of the recent crisis. The effective new standard for high-quality equity capital will now be the highest in recent history.

But Basel III is only part of regulators’ stability agenda. There is a risk that further steps may undermine the economic recovery. Policymakers are considering requiring certain large institutions — those deemed ‘systemically important’ — to hold even higher levels of capital.

Additional capital requirements on top of the already stringent Basel III levels are not cost free. Higher capital levels reduce the amount of credit that banks can extend and raise the cost of making loans — which in turn lowers the demand for credit.

The effect already can be seen in the U.S. economy, where loan demand is falling as the cost of credit rises. Smaller borrowers have been hit disproportionately hard.